Birmingham Investment & Trading society 1st feb

• To appreciate fully what it means to be an investor, I ask you to imagine that you do not live in the 21st
Century, with its vast range of financial instruments. You live in a simpler time. You are a member of the
Victorian class, and life has been good to you. A substantial nest-egg has been built up over the years,
but you are dissatisfied with the 2% annual return you are getting on it in the local bank.
• A couple of acquaintances, Mr Stephenson and Mr Brunel, are enthusiasts for a revolutionary
technology that will improve the lives of the British people tremendously: the railways. Although the
social benefits are wonderful, and it gives Stephenson and Brunel a warm feeling to think that they
might contribute to people’s well being, this is not their primary motivation. No, they like the idea of
becoming very wealthy. The way in which they expect to become rich is to build and operate a railway.
• There is one thing stopping them from building the railway: it costs £2 million to build the line and pay
for carriages, provide working capital for day-to-day needs etc. They only have £100,000 between them.
What a frustrating situation. They know that the railway will generate profits that dwarf the £2 Million
initial cost, and yet they can’t persuade a bank to put up the £1.9 million needed.
• An alternative approach of funding has been tried- indeed they suggested it to you as well as a couple
of dozen other investors. This is to form a partnership. Each partner puts in, say, £50,000 and the rest is
borrowed from a bank. Then, when the profits start to roll in (after paying the bank the interest) the
partners get an equal share. Of course, in addition Stephenson and Brunel would take a salary to
compensate them for giving up time to manage the railway. You and most of the other investors who
were approached rejected this offer for two very simple reasons. First, under partnership law each
partner is liable for all the debts of the business. So if the business failed to produce a profit and the
assets became worthless, and yet there are large bank debts, the bank would first of all try to get its
money back from the business. Its next move would be to claim the money it is owed to from each of
the partners. Business partners have been known to lose their houses, furniture, everything, in order to
pay of a business’s creditors. You have seen to many landed gentry made homeless to want to invest in
a business under a partnership, thus you decided to keep your money safe and not to risk it in industry
of any kind
• The second problem with partnerships arises if one of the partners wishes to leave (or dies). The leaving
partner is generally entitles to a fair share of the value of the partnership. This can be terribly disruptive
to a business, as assets may have to be sold to pay the partner off. Indeed, partnerships tend to be
dissolved if one member wishes to leave and then a new partnership is created to carry on the business
thereafter. It is certainly no way to run a railway.
• So the two issues Stephenson and Brunel have to deal with are: the Unlimited Liability of the investors:
and the continuity of business in the case of investors wishing (or forced) to de-invest.
• Fortunately there is a form of business structure that addresses these two difficulties that lead to a restricted
flow of funds from savers in a society to productive investment in real business assets: a company or
corporation is set up as a ‘separate persons’ under the law. It is the company that enters legal agreements
such as bank loan contracts, not the owners of the company shares. The company can have a perpetual life.
So, if an investor wishes to cash in his chips he does not have the right to insist that the company liquidate its
assets and pay him his share. The company continues but the investor sells his share in the company to
another investor. This is great- it gives managers the opportunity to plan ahead, knowing the resources of the
business will not be withdrawn; it gives other shareholders the reassurance that the company can achieve its
goals without disruption.
• One of the most important breakthroughs in the development of UK capitalism and economic progress was
the introduction of limited liability in 1885. There were strong voices heard against the change in the law. It
was argued that it was only fair that creditors to a business could call on the shareholders in that business to
beat the responsibility of failure. However, a stronger argument triumphed. That is that it is better for society
as a whole if we encourage individuals to place their savings at the disposal of entrepreneurial managers for
use in a business enterprise. Thus factories, ships, shops, houses and even railways will be built and society
will have more goods and services
• Insisting on unlimited liability for investors made them hesitant to invest and thus reduced overall
wealth. Limited Liability companies are what (for the most part) we have today, and we should be very
greatful for it. Creditors quickly adjusted to the new reality of lending without a gurantee other than
from the company. They became more expert and thorough in assessing the risk of the loan going bad
(credit risk) and they call for more information; legislators helped by insisting that companies published
key information.
• So back to your 19th century dilemma over whether to invest in Stephenson and Brunel’s brilliant idea.
What they intend to do is to create a company with limited liability for its shareholders. The company
will issue 1.5 million shares. Each share will have a par value of £1. Sometimes companies sell shares at
the par value and sometimes they sell them at greater than the par value. The par value (also called the
nominal or face value) is merely a nominal figure, useful for record keeping, but unrelated to the market
value of a share. In the case of Stephenson and Brunel Ltd, the shares are to be offered to investors at
par. The company also borrows £500,000 from a bank.
• The vast majority of shares issued by companies are ordinary shares. When you buy one of these you are
buying a set of legal rights. Significantly, one of the rights you do not receive is a guarantee of any return on
the money you hand over to the ordinary shares. The company, run by its managers, has no obligation either
to give you a dividend ( a pay-out or profit) or to hand your capital back. The managers may promise to do
their best with the financial resources entrusted to them, but they cannot be legally forced to give a return.
This contrasts sharply with the deal the company agrees with the bank lenders. Here the company is legally
responsible to provide regular interest payments and pay off capital at the end of the loam term.
• It does not sound like such a good deal for the ordinary shareholders. They pull money in, they cannot take it
out again (the best they can hope for is to sell the holding to another investor), and the company has no
obligation to pay the anything! But however, the other interested parties will get their guaranteed amounts
first. So if taxes are owed to Her Majesty’s Revenue and Customs (HMRC) gets its money, and then it’s the turn
of the various lenders and trade creditors (suppliers of goods and services not yet paid).
• Given these disadvantages of shares, there must be some thing attractive to entice investors. There is.
Shareholders own all the value that is created by a business after lenders and others have received the
amounts they are owed. If the business does well then it is perfectly possible for a £1,000 investment in
ordinary shares to become worth over £1 million. It has happened time and time again. There are
multimillionaires today who put relatively small amounts into companies destined to become market
leaders- Vodaphone, Glaxo, Amazon, Intel and Berkshire Hathaway-Warren Buffet for example.
• The power of that franchise starts to become apparent in the third year. The company makes a profit
(earnings), after paying interest and taxes, of £750,000. The directors now have a choice to present to
the equity holders (ordinary shareholders). The company could retain all of its earnings to invest in
extending the network ( retained earnings) or it could pay out some (or all) of it to shareholders in the
form of dividends. Note that, whichever course of action is taken, the money belongs to shareholdersearnings retained in a business are there because shareholders consent to their money being left there.
• Suppose the directors (with the agreement of the shareholders) decide on a 50 % payout ratio, that is,
half of the earnings after tax are paid out in dividends. The shareholders will receive a dividend of 25p
per share (£375,000 divided by 1.5000,000 shares)
• The retained earnings of £375,000 increases shareholders funds from £1,400,000 to £1,775,000. So
shareholders have not only received a 25p Dividend for each share they hold, but the retained earnings
have increased the asset value of each share in the company from 93.33 pence to 118.33 pence
(£1,755,000 divided by 1,500,000 shares)
• The London Stock Exchange performs two vital roles to encourage investors to invest in industry. The first is
the operation of a primary market. This is where companies sell shares to investors and then use the proceeds
in their businesses. Stok markets also provide secondary market where shares are traded between investors.
An efficient and trustworthy secondary market is needed to encourage investors to buy shares in the primary
market. Investors like to know that there is a place they can go to sell shares quickly, cheaply and without
having to reduce the price, that is, to sell at the going rate. In other words investors need a liquid market. A
liquid market is one where there are numerous competing buyers and sellers allowing the outcomes of many
buy and sell orders to set the market price. It is one where there is so much activity that the sale of 50,000
shares a day would not cause the price to fall; the market would quickly absorb he shares.
• The market also needs to be a fair game ( or a level playing field) and not a place where some investors,
brokers, fund raisers or financiers are in a position to profit unfairly at the expense of other participants. This
means for instance, that insider dealing is prohibited, that is, company officers or others with private
knowledge are forbidden to use that knowledge to trade in the company's shares.
• Brokers who act for shareholders are well regulated so that they act in the interest of investors. Market
Makers, who stand ready to buy and sell shares from investors on their own behalf in the stock
exchange, follow strict codes of behaviour. It is a market that is well regulated to avoid abuses,
negligence and fraud in order to reassure investors who put their savings at risk. Furthermore, investors
need information on how companies and share price activity so stock exchanges insist on minimum
standards of information flow from companies and help disseminate company announcements. They
also publish prices at which trading occurred and other share trading data (e.g. volume of trades)
• What have we learned?
• Is there anything in the news that is relevant and related?
• Discussion time
• Newspaper idea?
• Guest Speaker Dr Steve Walker